Q&A: What it would mean for the Fed to taper' bond buying?

specialist William Geier, left, works on the floor of the New York Stock Exchange. Investors took to the sidelines Tuesday, Dec. 17, 2013, a day ahead of a key policy decision from the U.S. Federal Reserve that may see the central bank reduce its massive monetary stimulus.

WASHINGTON — The magic word on Wall Street for much of this year has been “taper.” And so it is again this week, as the Federal Reserve meets to consider whether to do exactly that. Here’s what you need to know.

Q: What is tapering?

A: Slow down! First you have to understand the Fed’s practice of buying bonds, known as quantitative easing, or QE.

Q: OK, OK. What’s QE?

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The Fed normally manages the economy by either raising or lowering short-term interest rates. But it can’t cut that rate below zero, where it has been for almost five years. So the Fed has tried to stimulate the economy by pumping money directly into the financial system.

It does that by buying longer-term bonds, both U.S. Treasury bonds and mortgage-backed securities issued by government-sponsored companies Fannie Mae and Freddie Mac. The Fed creates money out of thin air (the electronic equivalent of printing money) and uses it to buy the bonds on the open market. Then the bonds are on the Fed’s books, and the newly created money is out in the banking system.

Currently, the Fed is buying $85 billion worth of bonds each month. The Fed’s total holdings, as of Dec. 11, topped $4 trillion, compared with around $800 billion before the financial crisis.

Q: So NOW can you explain what the taper is?

A: Yes! The Fed doesn’t want to end the bond buying cold turkey. It wants to slow the purchases gradually, and at a pace that can be adjusted depending on how markets and the economy react to the process. It wants to taper them off, not just end them.

The question is when to start tapering. The Federal Open Market Committee is meeting Tuesday and Wednesday, and its members will be debating whether to begin tapering QE. The committee will announce its decision Wednesday at 2 p.m., followed by a news conference by Fed Chairman Ben Bernanke. The markets will be holding their breath.

Q: What’s the case for tapering now?

A: It goes like this: QE isn’t meant to go on forever, so you need to start winding it down sometime. That sometime may as well be now.

The policy seems to be having diminishing benefits, in the sense that going from, say, $3.5 trillion to $4 trillion in assets on the Fed balance sheet didn’t help markets and the economy as much as going from $2.5 trillion to $3 trillion. And it may be creating some unhappy side effects, such as bubbles in emerging-market bonds or for some types of corporate debt.

And the economic recovery is looking a good bit more solid than it did when the Fed met in September, averaging nearly 200,000 net new jobs a month this fall. The unemployment rate is down to 7 percent, from 7.6 percent in June. After the confidence-rattling partial government shutdown in October, there is now a budget deal nearing passage that would prevent more shutdowns for the next two years and lessen the amount of drag that fiscal policy is putting on the economy.

And the Fed is looking to shift its approach to stimulating the economy away from bond buying and toward using communications about the future path of interest rates. In theory, if the central bank can successfully persuade people that it won’t raise interest rates until the distant future, that should have the same impact on the economy as buying bonds, without some of the nasty side effects.

Against that backdrop, it’s time to start the wind-down. That’s what the pro-taper folks will argue at the meeting, anyway.

Q: What are the arguments against tapering now?

A: Oh, sure, they will say, there have been a couple of months of decent economic data. But we’ve seen this show before. Every time the economy seems to be getting out of its rut, the Fed starts heading for the exits and things get worse. We need to see a little more evidence that this faster recovery is truly entrenched before we even think about ending QE.

Second, even with growth looking a little better, inflation is still way too low — 1.1 percent by the Federal Reserve’s preferred measure (the price index for personal consumption expenditures excluding food and energy). The Fed says it aims for 2 percent inflation; and to start winding down the money-printing operation when inflation is still too low could cost the central bank credibility.

Finally, don’t be so sure that the battle to separate short-term interest rates from QE is won. Yes, there’s been some clear progress on that front in the past few years, but if we seem too eager to pull away the punch bowl of bond buying, markets will inevitably assume we will do the same for low-interest-rate policies.

Q: So is there a way the people making these arguments might compromise?

A: There is. For example, Fed officials could agree to begin tapering bond purchases, but to start small (like reducing from $85 billion to $80 billion or $75 billion). They could announce plans to begin the tapering a month or two down the road, not immediately.

And they could consider tapering the bond buying but complementing it with new strategies to try to bolster the credibility of their communications. For example, they could say, “Whoops, we’re not going to think about raising interest rates when unemployment is 6.5 percent. We’ll wait until it’s 6 percent.” Or they could state that they won’t hike rates as long as inflation looks on track to be below, say, 1.5 percent.

In other words, if they do taper, there’s a good chance it will be in conjunction with other steps to affirm the Fed’s seriousness about trying to stimulate the economy.

Q: So, what are they going to do?

A: Nobody knows for sure. It looks to be a close call. That’s what will make Wednesday afternoon interesting for anybody who cares about the economy or markets. Stay tuned!